What is Europe’s Liquidity “Bandage” Hiding?

One big concern for long-term investors is systematic risk, or risks that are endemic to an economy as a whole. Systematic risks, as opposed to company-specific risks, were behind the majority of the pain suffered during the global financial crisis. And I tend to think that in the United States, the systematic risks that came to a peak in 2007 were purged from the system pretty effectively by the intensity of that same financial crisis.

Europe, though, I fear still has a lot of systematic risks that are being masked by the massive liquidity injections from the European Central Bank. Like a bandage that’s covering a particularly nasty wound, programs like the LTRO (Long Term Refinancing Operations) are perhaps stopping the hemorrhaging, but they’re also obscuring complications that lie beneath.

A program like the LTRO has led to “round trip” financing of the debt of troubled governments by the European Central Bank through to those countries’ own local banks. I can’t but feel that this will all end somewhat badly for the Eurozone sometime in the next two to four years. Let’s say Spain defaults on its sovereign debt in the coming year or two. As it stands now, that default would hit local Spanish banks (big holders of Spanish sovereigns), and the ECB (another big holder of Spanish debt), and…and not many other people hold their bonds.

If you extrapolate that out to other troubled economies in southern Europe, I suspect that systematic risks would include the potential undermining of the Italian, Spanish, and Portuguese banking systems. It’s likely this bandage of liquidity that’s preventing this systematic risk from showing up in conventional volatility spreads.

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